China transfer pricing – first mover on BEPS
In July 2016, China’s State Administration of Taxation (SAT) released Announcement 42, outlining the updated Chinese requirements for contemporaneous documentation. In October, it released Announcement 64, containing revisions to the guidance on the administration of advance pricing arrangements. Chi Cheng, Xiaoyue Wang, Simon Liu, Kelly Liao and Mimi Wang explore the implications.
Against the backdrop of the OECD's Base Erosion and Profit Shifting (BEPS) initiative, tax reform in China over the past few years has maintained a rapid pace, taking observers along on a breath-taking ride while keeping them on the edge of their seats as to what will happen next.
Underlying the recent flurry of activity, as noted in a paper written by Dr Liao Tizhong, director of the international tax division of the SAT, following the 2016 G20 Hangzhou Summit, is China's increasing eagerness to become an active participant in the international tax reform process. At the same time, the updated regulations also reflect the SAT's genuine interest in updating and modernising its practices in the tax administration process, making it more systematic, efficient and service oriented. In less than a decade, China has come a long way from having a dearth of transfer pricing (TP) regulations to now being one of the earliest adopters of the OECD's BEPS Project on the global stage.
The SAT's public consultation draft guidance, issued in September 2015, to provide for the implementation measures of "special tax adjustments" (the discussion draft), outlines the SAT's conceptual approach to adopting the BEPS proposals. It addresses those areas that were already of particular importance from the Chinese TP perspective, such as value creation and location specific advantages (LSA). Effectively, the discussion draft has set the foundation and provided direction for future regulatory updates.
A little over a year since the discussion draft was published, the public release of the Announcement on the Enhancement of the Reporting of Related Party Transactions and Administration of Contemporaneous Documentation (Announcement 42) on July 13 2016 marked the first of a series of official regulatory reforms by the SAT in the area of TP. This was followed closely by the public release of the Announcement on the Enhancement of Administration of Advance Pricing Arrangements (APAs) (Announcement 64) on October 18 2016, with future announcements certain to be forthcoming.
Regulatory reform in China has also cascaded down to the local level with provincial tax administrations quick to integrate BEPS-driven international tax reforms as part of their modus operandi. In particular, the Jiangsu provincial office of the SAT (Jiangsu Office) issued a 2016-18 Compliance Plan on International Tax Administration (Jiangsu Compliance Plan), in which specific references are made to enhancing the quality of BEPS documentation and taxpayers are encouraged to use value chain based transfer pricing methods, such as the value chain apportionment method proposed in the discussion draft. It is clear that taxpayers will face increased pressure to demonstrate that their TP practices are consistent with the compliance requirements as set out by the SAT. They will therefore be challenged to balance compliance requirements with the administrative costs of doing so.
Announcement 42 integrates BEPS principles with Chinese focus
Announcement 42 demonstrates the SAT's intention to align its contemporaneous documentation requirements with those in other OECD countries, while incorporating a special focus, into the Chinese standards, on those areas that have traditionally been important to the Chinese tax authorities. Moreover, the compliance requirements introduced in Announcement 42 are emphasised by Announcement 64, demonstrating the SAT's holistic and integrated approach in drafting the new regulatory guidelines.
The most pronounced structural change to contemporaneous documentation requirements under Announcement 42 is the formal adoption of the three-tiered documentation approach as envisaged by BEPS Action 13. This supersedes the previous single report approach under Chapters 2, 3 and Articles 74 and 89 of the SAT Circular on Implementation Measures for Special Tax Adjustments (Trial Implementation), Guoshuifa (2009) No. 2 (Circular 2). Looking ahead, multinational enterprises (MNEs) meeting specific reporting criteria must prepare the master file, the local file, and the country-by-country (CbC) report. The latter report must be submitted as a part of the related party transaction forms filed with the annual corporate tax return.
While the requirements for the master file under Announcement 42 broadly follow the guidelines in the BEPS Action 13 report, one of the more notable areas where the SAT seeks additional information through the master file is with respect to an MNE's research and development (R&D) activities. This is an area that the SAT has historically emphasised in relation to the concept of value creation.
Announcement 42 requires disclosure of detailed information of activities, including functions, risks, assets and personnel associated with principal facilities performing and managing R&D, in addition to disclosure of where these facilities are located. This allows the Chinese tax authorities to better understand whether the R&D entities are actually responsible for performing the principal work, and where eventual profits should reside.
New requirements for the master file provide the SAT with more information about the taxpayer's restructuring activities during the year. Underlying this is the SAT's increased scrutiny of both direct and indirect related-party equity transfers. This theme is also carried over to the local file reporting requirements. The SAT would like to understand the nature of the MNE's legal reorganisations during the year, such as debt restructuring, equity acquisitions, mergers and acquisitions, and divestitures, in addition to its business restructuring activities, including activities that involve adjustments of its industrial structure, and transfers of functions, risks and assets.
Although the BEPS Action 13 report only requires disclosure of unilateral APAs, Announcement 42 goes beyond this and requires disclosure of bilateral APAs entered into by all entities of the MNE. Furthermore, the entity filing the CbC report on behalf of the group and its location must be disclosed. As such, MNEs must pay additional attention when preparing the master file to ensure that its contents meet the Chinese requirements.
The updated guidelines under Announcement 42 provide MNEs with considerable flexibility in deciding how to best structure and present their master file. However, within this greater latitude taxpayers must think more strategically about the level of disclosure made not only within the master file, but also between the master file, the local file and the CbC report. A balance must be struck between providing sufficient information to the tax authorities and confining disclosure solely to information that is pertinent. Taxpayers also need to think about and anticipate who the potential readers of the document may be and whether the document is shared with different tax authorities, some of which are more experienced in dealing with TP issues than others.
Over the past several years, in tandem with China's economic development and the movement away from being purely a routine manufacturing or services centre, the SAT is increasingly emphatic about ensuring that China receives its "fair share" of an MNE's total profits, proportionate to the functions performed, risks borne and assets utilised by local Chinese entities. Hence, one of the most pronounced areas where Announcement 42's requirements extend beyond the BEPS Action 13 report, and indeed beyond the old Circular 2 guidance, is the new value chain analysis that must be included in the local file. Specifically, taxpayers are asked to provide a wide array of information including an overview of the attribution of the MNE's global profits to the different countries within the MNE's value chain, based on how profits are allocated across the value chain and the actual amounts of profit earned by each value chain participant. In addition, quantification and attribution of profits arising from LSA factors must also be disclosed in detail, to the extent that location savings and market premiums impact the pricing of related party transactions (RPTs). Information on the company's contribution to the overall profits or excess profits of a MNE must also be included in the local file submission, regardless of the choice of TP method, along with standalone and consolidated financial statements. Finally, the transactions, goods and funds flows, within each value chain in the MNE group, must be clearly explained, beginning with initial design and development of goods through to production, marketing, delivery, after-sales service and recycling. These requirements represent a fairly ambitious wish list by the SAT. To the extent that this information is available and can be provided by the taxpayer, the SAT will be able to better assess whether MNEs are paying their fair share of profits in China. However, it remains to be seen as to whether taxpayers will be able to provide this detailed level of information.
Requirements for entities to prepare the local file under Announcement 42 are more rigorous compared to the thresholds set under Circular 2. In addition to requiring entities, whose RPTs involving transfer of tangible assets exceeding RMB 200 million ($29 million) or other RPTs totalling more than RMB 40 million, to prepare local files, entities with transfers of financial assets exceeding RMB 100 million or transfers of ownership of intangible assets that are greater than RMB 100 million are also required to prepare documentation. This further reflects the significance of these types of transactions in the eyes of the SAT. Given the relatively low thresholds set for transfers of financial assets and intangible assets, more entities are likely to have to meet the criteria for preparing documentation, than was the case in the past.
One area where Announcement 42 specifically diverges from the OECD's BEPS requirements is the SAT's decision not to adopt the requirement for simplified documentation for low value-added intragroup services. This reinforces the SAT's long-standing position that all services transactions are considered to be potentially high risk, capable of shifting profits out of China. Clearly, as with the master file, the requirements for the local file under Announcement 42 reflect the SAT's desire to adapt and tailor BEPS Action 13 initiatives to China's unique circumstances.
The SAT has eagerly awaited the opportunity to obtain the type of information contained in the CbC report, as it has long stressed the importance of being able to obtain information on MNE businesses on a global basis. With the introduction of the CbC reporting (CbCR), tax authorities are now able to assess the impact of TP on an MNE's profitability in each jurisdiction in which it operates. Reportable items in the CbC report such as revenue generated through transactions with third parties as well as related parties, profit (or loss) before income tax, income taxes accrued and taxes paid, stated capital, number of employees, etc. allow tax authorities to understand how functions performed correspond to returns generated and potentially relevant tax positions of the entities in the relevant jurisdictions and, equally importantly, across the value chain.
Many MNEs have spent the past year conducting CbCR "dry-runs" using 2015 data before the deadline for submitting the 2016 data, the first taxation year in which CbCR applies. Early evidence from a number of the larger MNEs indicate that the May 31 filing deadline represents a fairly aggressive target for large organisations to meet, given that final year-end data are typically not available until February or March of the following year at the earliest. Therefore, one of the most crucial aspects of CbCR is for companies to map out and implement a systematic process for data collection, aggregation, review and reporting. Involvement of the systems IT personnel early on in the process can be beneficial, especially for organisations that anticipate significant enhancements to their IT systems.
Discussions with taxpayers also indicate that there is some flexibility in the interpretation of certain reportable items. For example, there is some discussion as to whether stated capital should be consolidated within the same tax jurisdiction. While MNEs can interpret the wording in BEPS Action 13 to represent a simple aggregation of all stated capital, in reality simply adding together all stated capital may potentially enlarge the total to a multiple of its actual level, depending on the number of consolidation levels and therefore, grossly over-represent the total stated capital. The same issue of whether or not to consolidate also extends to the related-party revenues within the same jurisdiction. We have seen some MNEs consider an approach that consolidates intra-country related-party revenue to make certain ratio analyses more meaningful. To this end, taxpayers may want to retain the flexibility to adopt the interpretation that is the most consistent with the economic substance of their operations.
The CbC report provides a high level summary of an MNE's activity in each jurisdiction at a high-level and is not meant to replace the more rigorous TP analysis of functions, risks and assets as contained in the local file. Moreover, as the basis for CbCR is on a jurisdictional rather than on an entity level, the master file and the local file must be reviewed in conjunction with the CbC report for the tax authorities to identify potential investigation targets.
Related-party relationships and transactions
Adopting the principles set out in the discussion draft, Announcement 42 provides clarification regarding when related-party relationships are deemed to exist. In addition to the most commonly observed direct and indirect ownership criteria, entities may be deemed to be related through their:
Rights to access and use intangible assets belonging to one of the parties;
Through common familial relationship at the ownership level; or
When one entity exercises substantive control over another entity's business operations.
Notably, the updated definitions are more comprehensive compared to what was previously outlined under Circular 2, consequently expanding the scope of related-party relationships.
In addition to related-party relationships, the SAT has also incorporated financial asset transfers into the fold of RPTs, which can be seen as a clear signal of the SAT's growing attention to this area. Related-party financing and related-party services transactions are also defined in further detail. Therefore, the taxpayer burden for disclosing information has notably increased.
Annual reporting forms of related-party transactions
The revamped related-party transaction reporting forms under Announcement 42 represent both an increase in the quantity of forms – up to 22 forms from the nine forms under the previous Circular 114 – and the level of detail required to be disclosed.
The SAT's focus on the key areas of interest is also evident through the design of the forms. For example, there are now two forms related to intangible assets, one related to the transfers of ownership of intangible assets and a separate form related to the transfers of rights to use intangible assets, replacing the previous Intangible Asset Transaction Form under the previous Circular 2. A separate form is also required to disclose financial assets transactions such as:
Assets from derivative instruments; and
Other financial assets.
The CbCR forms, making up six out of the 22 forms, in English and in Chinese, line up with each of the three template CbCR tables presented in the BEPS Action 13 guidelines.
Underlying the changes in reporting requirements, as outlined under Announcement 42, are the principles that the SAT has always been promoting:
Contribution to value creation of intangibles should be properly remunerated, performance of activities that relate to the creation of intangible assets should also be considered in addition to the ownership of intangible assets;
Local specific advantages in the form of location savings and market premium should be considered;
Contractual mismatching of functions and risk, such as in the case of low cost-plus return on key R&D activities, should be avoided; and
All services transactions are considered to be potentially high risk and therefore should be examined in detail.
With the formal adoption of these principles into SAT guidance, it becomes the taxpayer's responsibility to demonstrate and prove that their TP practices are in line with the principles outlined by the SAT.
Jiangsu Tax Office and the 2016-18 Compliance Plan
Shortly after the release of Announcement 42, the Jiangsu provincial office of the SAT issued its 2016-18 Compliance Plan on International Tax Administration.
Although this plan aligns closely with the areas of focus outlined under Announcement 42, the Jiangsu Compliance Plan further stresses, in unequivocal terms, the importance of improving the overall quality of TP documentation, effectively raising the compliance bar for taxpayers. Taxpayers are also encouraged to use value chain based transfer pricing methods such as the value chain apportionment method proposed in the discussion draft.
Also explicitly noted in the plan is a requirement for tax intermediaries to apply their professional skills to help enterprises improve the overall quality of the documentation. Interestingly enough, it is noted that "for those intermediaries and their employees engaging in the preparation of documents which exhibit poor quality, the tax authorities will make them known". Ultimately, those taxpayers whose documentation is considered to be of poor quality will be attributed with a higher risk rating by the tax authorities for the purpose of identifying potential audit targets. By highlighting the role of the professional intermediary, the Jiangsu Compliance Plan brings the interests of the taxpayer, their professional advisers, and the SAT closer in line.
Announcement 64 reflects SAT's objective of transparency
In the decade between 2005 and 2014, over 100 successful APAs were signed by the SAT with unilateral APAs accounting for approximately 70% of the total, and bilateral APAs making up the remaining 30%. Announcement 64 incorporates the experience accumulated, technical experience gained and systematic processes developed by the SAT since the release and implementation of Circular 2. These updated regulations also reflect the SAT's aspiration to develop and refine a more systematic and transparent approach to APAs and more robust administrative procedures for their implementation. At the same time, these regulations embody the key transparency principle underlying the BEPS Action Plan, in which China has actively participated since the beginning. With these updated requirements, there is general consensus that the threshold for the successful acceptance of an APA is higher and more rigorous compared with those under Circular 2.
The updated Announcement 64 follows a six-stage process, with the stages of:
Analysis and evaluation;
Signing and supervision of implementation.
Notably, the analysis and evaluation stage has been brought forward before the formal application stage. The new six-stage process is generally consistent with what takes place in practice for unilateral APAs. However, it does raise some challenges for bilateral and multilateral APAs given that the other competent tax authorities may or may not start their detailed analysis and evaluation work until an APA application has been formally accepted. This means that, going forward, taxpayers who are interested in bilateral or multilateral APAs involving China must engage in detailed discussions with all competent tax authorities early on in the process to make sure that their negotiation positions are well managed, in order to avoid situations where agreements reached with the SAT are considered unacceptable to other competent tax authorities.
The frontloading of the analysis and evaluation stage demonstrates the SAT's push for additional preparation work to be performed before the formal application stage, and requires taxpayers to adopt a more efficient and accurate approach at the outset. Materials that would have been required to be submitted at a later stage under the current system will be fast-tracked to the initial stages. For example, the APA pre-filing application in the initial stage requires inclusion of:
An extensive and detailed description of the transactions involved and the years to be covered under the APA;
A description of the businesses' operations and the most recent three to five years of contemporaneous documentation;
An explanation of the functional analysis associated with the transactions to be covered; and
A description of market conditions, including any LSAs that may exist.
Successful continuation of the application past the initial stage sets the groundwork for the submission of an APA Letter of Intention and APA Application Draft.
The Application Draft will require the taxpayer to disclose the TP methodology and calculation method proposed under the APA, functional and risk analysis, as well as comparability analysis along with any assumptions used in devising the methodology applied. A detailed value chain or supply chain analysis will be presented at this stage along with information on the business scale including forecasts and business plans for the period covered by the APA. By frontloading these requirements, the submission of the Formal Application Letter and Report will become a procedural formality.
It is obvious that there are consistent themes across both Announcement 42 and Announcement 64. This reflects the SAT's systematic and integrated approach when designing these new standards to raise the level of sophistication of updated tax regulations. For example, taxpayers are asked to discuss any relevant LSAs, including location savings and market premiums, at the pre-filing stage of the APA application and to provide value chain or supply chain analysis later on in the analysis and appraisal stage.
Furthermore, Announcement 64 notes that if the applicant has not filed their contemporaneous documentation or annual reporting forms for related parties that satisfy the criteria under Announcement 42, their application may be denied on this basis. As such, Announcement 64 mutually reinforces and upholds the requirements set out under Announcement 42.
It is also particularly interesting to note that, under the new administrative mechanism in Announcement 64, the tax authorities will issue a Notice of Additional Taxes to be Paid/Tax Refund calculated for the years covered or retroactively applied under the APA. This is the first time the SAT has opened the door for refunds to be granted arising from TP adjustments. Indeed, if applied in practice, this would make China an exception among the global tax authorities in allowing adjustments of this type. However, it remains to be seen whether these adjustments will be observed in practice going forward.
China Country Practices
The United Nations Practical Manual on Transfer Pricing for Developing Countries (the Manual) was first issued in 2013, with the SAT then contributing a section on China Country Practices. In October 2016 the SAT updated this document, setting out what it perceives as the TP opportunities and challenges for developing countries in the post-BEPS era.
The SAT has been consistently under-resourced. In response to the increased workload related to TP audits and bilateral negotiations in the post-BEPS era, the SAT has set up three anti-avoidance divisions in its headquarters. Sixteen people were recruited in 2016, with 26 more expected to join the team in the next two years. Eventually a 50-person team dedicated to transfer pricing will be working in the SAT headquarters. This significant increase in personnel at the SAT headquarters will have a profound impact on TP audits and bilateral negotiations over the coming years. In particular, it is likely that there will be more nationwide audits led or coordinated by the SAT, as well as greater consistency in the assessment of similar cases.
The SAT, in the same manner as in the previous version of the China Country Practices document, emphasised the difficulties encountered when applying the arm's-length principle in developing countries, in particular due to a lack of reliable comparables. The SAT also stressed the need to perform comparability adjustments when companies in developed countries are used as comparables for companies in developing countries. The SAT again emphasised factoring in the impact of location-specific advantages, such as the so-called "location savings" and "market premium", in performing TP analyses in developing countries.
While not challenging the overarching role of the arm's-length principle in TP, the SAT states clearly that China's TP regime has drawn on some other internationally recognised rules besides the arm's-length principle. Indeed, the SAT encourages research to be conducted to explore better alternatives to the arm's-length principle. The value chain apportionment method, proposed in the discussion draft, is considered by many to be a departure from the arm's-length principle. It will be interesting to see if the value chain apportionment method will be sanctioned as a formal TP method in one of the additional TP regulations that the SAT is expected to release in forthcoming months.
Conclusion and look-ahead
With the release of Announcement 42 and Announcement 64, it is widely anticipated that additional guidance on TP investigations and audits will be forthcoming in the coming months. Based on the guidance provided in the discussion draft, the SAT is likely to adopt a more sophisticated approach to examining taxpayer internal control procedures in the context of conducting tax audits, providing impetus for taxpayers to develop a more robust tax risk management system. The SAT has also hinted that it will implement a risk based approach in identifying target enterprises as well as increasing its reliance on the use of "self-investigations" by the taxpayer.
As the SAT continues to release additional regulations in the forthcoming months, taxpayers will need to vigilantly monitor these changes and carefully balance their approach to meeting the new compliance requirements, while managing the administrative burdens associated with compliance.
In the course of the past decade, China has transformed itself from having virtually no formal TP requirements until 2008, to now being one of the first countries to formally adopt the OECD's BEPS Action Plan into local rules. This demonstrates China's eagerness to become an active and integral part in transforming the global tax system. Undoubtedly, more changes are ahead for China in this age of international tax reform.
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Based in Shanghai, Cheng Chi is the partner-in-charge of KPMG's global transfer pricing services for China and Hong Kong. Before returning to China in 2004, Cheng started his transfer pricing career in Europe with another leading accounting firm based in Amsterdam. He has led many transfer pricing and tax efficient supply chain projects in Asia and Europe, involving advance pricing arrangement negotiations, cost contribution arrangements, Pan-Asia documentation, controversy resolution, global procurement structuring, and headquarters services recharges for clients in the industrial market, including automobile, chemical, and machinery industries, as well as the consumer market, logistic, communications, electronics and financial services industries.
In addition to lecturing at many national and local training events organised by the Chinese tax authorities, Cheng has provided technical advice on a number of recent transfer pricing legislative initiatives in China. He has been recommended as a leading transfer pricing adviser in China by the Euromoney Legal Media Group since 2009 and as a tax controversy leader by International Tax Review.
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Xiaoyue Wang joined KPMG China recently, with a base in Hong Kong. As a special adviser on transfer pricing, she supports clients on critical and strategic transfer pricing issues.
Prior to joining KPMG, she had a distinguished career in international tax administration with the State Administration of Taxation (SAT), rising through the ranks to deputy director general of the international tax division. In various capacities, she represented China in international negotiations and inter-governmental cooperation on tax administration matters, led the drafting and promulgation of all major transfer pricing and anti-avoidance legislations to date, and developed a highly effective national structure for transfer pricing and anti-avoidance administration within the SAT.
Xiaoyue has a PhD in economics from the Renmin University of China and an LLM in taxation from Golden Gate University in the US.
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Simon Liu is a tax partner in KPMG's Beijing office. He has been involved in providing various China tax and transfer pricing advisory, and compliance services to multinational enterprises and Chinese domestic companies since 2003.
Simon has been actively involved in advising clients on various issues such as M&A, corporate restructuring and market entry feasibilities, based on Chinese state regulations and special local rules, policies and practices. He is experienced in delivering creative and practical solutions, and planning ideas which not only cover tax but also regulatory, customs, and foreign exchange issues. He also has extensive experience in transfer pricing and of cost sharing arrangements.
His technical expertise covers transfer pricing documentation, planning, and investigation defence; cross-border tax structuring; tax-efficient supply chain management and economic valuation for intra-group restructuring.
Simon has bachelor degrees in engineering and commerce from the University of Melbourne, and is a certified management accountant.
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Kelly Liao is a partner in KPMG China, based in Southern China. She started her professional career in 1999 and has extensive working experience in China, Hong Kong and Finland.
Kelly became specialised in transfer pricing in 2004. She has been actively assisting multinational enterprises in transfer pricing dispute resolution, value chain planning, rationalising transfer pricing policies, formulating cost recharging policies, applying for advance pricing arrangements and preparing transfer pricing documentation in China.
Kelly's clients include a number of multinational enterprises in a wide range of industries, including infrastructure, chemical/oil and gas, consumer goods, retail, electric and electronics, property development, pharmaceuticals, machinery, finance and e-commerce.
She is a Chinese Certified Public Accountant, Chinese Certified Tax Agent, Hong Kong Certified Tax Agent and is a member of the Association of Chartered Certified Accountants.
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Mimi Wang is a partner with KPMG's global transfer pricing services based in Shanghai, serving clients in a wide range of industries. Mimi started her transfer pricing career in London in 2005 and relocated to China in 2012.
Mimi has managed many multi-jurisdictional planning studies, documentation and has participated in the negotiation of unilateral and bilateral advance pricing agreements and audit assessments. She has experience in a wide range of transfer pricing issues, including tangibles, intangibles, intra-group services, intra-group financing, business restructurings, etc. Mimi also has significant experience in business and intellectual property (IP) valuations.
As a member of KPMG China's BEPS centre of excellence, Mimi is also responsible for analysing BEPS implications to clients with operations in China. She has delivered training to tax officials and participated in discussions with senior State Administration of Taxation (SAT) officials on topical transfer pricing issues.
Mimi has a bachelor's degree from the London School of Economics and is a chartered accountant with the Institute of Chartered Accountant of England and Wales.